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The Green Budget
The Economic Outlook
January 2005
Professor David Miles +44 20 7425 1820 [email protected]
Morgan Stanley does and seeks to do business with companies covered in its research reports. As a result, investors should be aware
that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as
only a single factor in making their investment decision.
The Economic Outlook

The UK economy has been unusually stable in recent years. But there is
no strong evidence that there has been an increase in the sustainable
long-term growth rate of the economy.

The Treasury believes that the sustainable ‘trend’ growth rate of the
economy is 2.75% a year, falling to 2.5% in 2007. This looks plausible.

But our analysis suggests that there is little or no spare capacity in the
economy – this is important for estimating when the cycle ends and for
near term growth prospects .

We think growth will be somewhat weaker than the Treasury forecast in the
short term, but its longer-term projections look plausible.

But there is the risk of a more dramatic slowdown if the household sector
decides to sharply increase its saving rate from the current low level.
Please refer to important disclosures at the end of this presentation
Economic growth less variable than in the past
11
UK GDP (volume, Y%)
9
7
5
% 3
1
-11957
1966
1975
1984
1993
2002
-3
-5
Source: ONS
Please refer to important disclosures at the end of this presentation
Inflation has been low and stable since the mid 1990’s
30
CPI - inflation
RPI - inflation
25
20
% 15
10
5
0
1957
1966
1975
1984
1993
2002
Source: ONS
Please refer to important disclosures at the end of this presentation
Annual growth and inflation by decade
19571964
19651974
19751984
19851994
19952004
Growth in real GDP
3.3
2.7
1.5
2.6
2.8
Growth in real GDP per capita b
2.6
2.3
1.5
2.3
2.4
Variability of real GDP growth
(standard deviation of annual change)a
2.6
2.3
2.4
2.2
0.7
Variability of retail price inflation
(standard deviation of annual change)a
1.6
3.8
6.3
2.5
0.8
a Standard deviation of the year-on-year percentage change using quarterly data. b Real GDP per resident population;
2004 is a Morgan Stanley estimate. Other indicators are year-to-date.
Sources: ONS, Morgan Stanley research
Please refer to important disclosures at the end of this presentation
UK per capita output catches up with its European peers
% of US
1980
1990
2000
2003
66
67
72
74
77
75
73
72
80
78
72
70
74
74
71
71
100
100
100
100
UK
France
Germany a
Italy
US
a West Germany through 1990. Source: OECD, Constant 1995 prices and PPP,
Morgan Stanley Research Estimates
Please refer to important disclosures at the end of this presentation
Cycles, Capacity and Trend Rate of Growth

Where we are in the business cycle and what future cycles and
trend growth look like is crucial in assessing the fiscal outlook.

We look at a range of evidence on the issues.

Simple statistical techniques suggest no spare capacity.

Looking at the capital stock and conditions in the labour market
gives a similar picture.

The evidence for a sustainable improvement in the rate of growth of
the economy over the medium term looks thin.
Please refer to important disclosures at the end of this presentation
Hodrick-Prescott measures of spare capacity
9%
1600
HP 100
HMT
7%
5%
3%
1%
-1%
-3%
-5%
-7%
-9%
1980Q2
1984Q2
1988Q2
1992Q2
1996Q2
2000Q2
2004Q2
Source: ONS and Morgan Stanley Research
Please refer to important disclosures at the end of this presentation
Hodrick-Prescott and Christiano-Fitzgerald (CF) measures
of spare capacity
9%
1600
CF
HMT
7%
5%
3%
1%
-1%
-3%
-5%
-7%
-9%
1980Q2
1984Q2
1988Q2
1992Q2
1996Q2
2000Q2
2004Q2
Source: ONS and Morgan Stanley Research
Please refer to important disclosures at the end of this presentation
Alternative estimates of spare capacity
Method
HP filter (λ= 1600)
HP filter (λ= 3600)
HP filter (λ= 100)
CF filter
Linear trend
HM Treasurya
Q1 2004 (% GDP)
0.0
-0.2
0.2
0.8
1.2
-1.0
Q2 2004 (% GDP)
Q3 2004 (% GDP)
0.3
0.1
0.4
1.0
1.5
-1.0
0.1
-0.1
0.1
1.0
1.3
-1.0
Source: HM Treasury, Statistics Office. Morgan Stanley Research. Note: The linear trend is estimated via
Ordinary Least Squares (OLS).
Note: negative numbers imply spare capacity; positive numbers imply output is above trend
a % of potential output
Please refer to important disclosures at the end of this presentation
Employment and unemployment headcounts (million)
3.5
29
Unemployment (LHS)
Employment (RHS)
28
3.0
27
2.5
26
2.0
25
1.5
1.0
1984
24
23
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
Source: ONS, DataStream
Notes: UK LFS employment, unemployment levels in million, headcount.
Please refer to important disclosures at the end of this presentation
Employment and participation rates (%)
82.0
81.5
81.0
80.5
%
Participation (LHS)
Employment (RHS)
76
75
74
80.0
73
79.5
72
79.0
71
78.5
78.0
77.5
%
70
69
77.0
68
1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004
Note: Percentage of working age population. Sources: HM Treasury and ONS.
Source: Labour Force Survey, ONS, DataStream. Participation rate: percentage of working-age population
who are economically active.
Please refer to important disclosures at the end of this presentation
Ratio of output to the stock of capital
0.60
Fitted trend
Actual
0.56
0.52
0.48
0.44
0.40
1987
1989
1991
1993
1995
1997
1999
2001
2003
Source: ONS. Morgan Stanley Research Note: net of residential housing
Please refer to important disclosures at the end of this presentation
Net national saving rate as % GDP
8
National net saving rate
7
6
5
%
4
3
2
1
0
1987
1989
1991
1993
1995
1997
1999
2001
2003
Sources: ONS and DataStream
Please refer to important disclosures at the end of this presentation
Treasury and Morgan Stanley trend growth estimates
MS Benchmark case
HM Treasury
(HP lambda=1600)
CF Band pass Filter
1986H1
- 97H1
2.55
2.44
2.50
1997H2
- 01Q3
3.06
2.98
3.02
2001Q4
- 06Q4
2.75
2.55
1.90 - 2.10
2007Q1
- 09Q4
2.50
2.55
2.45
Source: ONS and Morgan Stanley Research
Please refer to important disclosures at the end of this presentation
Treasury forecasts for key economic variables
Year-on-year growth (%)
2003
(outturn)
2004
2005
2006
2007
Real GDP
2.25
3.25
3.00-3.50
2.50-3.00
2.25-2.75
Domestic demand
2.5
4.00
3.00-3.50
2.50-3.00
2.25-2.75
2.25
3.25
2.25-2.75
2.00-2.50
2.00-2.50
General government
consumption
3.50
4.50
3.00
3.00
2.50
Fixed investment
2.25
6.50
6.75-7.25
3.25-3.75
2.75-3.25
Exports
0.0
2.25
6.50-7.00
6.25-6.75
6.25-6.75
Imports
1.25
4.75
6.00-6.25
5.25-5.75
5.25-5.75
CPI (Q4)
1.50
1.25
1.75
2.00
2.00
Nominal GDP
5.25
5.50
5.75-6.00
5.25-5.75
5.00-5.50
Household consumption
Sources: HM Treasury 2004 Pre-Budget Report (December 2004)
Please refer to important disclosures at the end of this presentation
The Economic Outlook

The near term forecast of HMT depends upon fairly strong growth
in exports and no very significant slowdown in consumer spending
growth.

There are obvious risks to that forecast – and in terms of overall
demand the risks are probably more on the down side.

Conditions in the housing market and a starting point with very low
household saving suggest slower consumer growth is likely.

Morgan Stanley expects slower growth in the global economy and
with sterling probably overvalued a sharp rise in exports this year
looks unlikely.
Please refer to important disclosures at the end of this presentation
Income to house price ratios relatively high
5.0
ODPM - House Price to Income Ratio (based on lenders data)
4.5
4.0
3.5
3.0
2.5
2.0
1969
1973
1977
1981
1985
1989
1993
1997
2001
Source: Office of the Deputy Prime Minister
Please refer to important disclosures at the end of this presentation
Mortgage payments still relatively affordable
16
Debt servicing as % post-tax income
15
14
13
12
% 11
10
9
8
7
1988
1990
1992
1994
1996
1998
2000
2002
2004
Source: Bank of England, ONS and Morgan Stanley Research
Note: interest payments plus mortgage principal payments as % post tax household income.
Please refer to important disclosures at the end of this presentation
House prices and the saving ratio
14
40
Household savings ratio (LHS)
Halifax house prices (RHS, %Y) 35
12
30
25
10
20
%
8
15
6
10
%
5
4
0
-5
2
-10
0
1984
-15
1988
1992
1996
2000
2004
Source: Bank of England, ONS and Morgan Stanley Research
Please refer to important disclosures at the end of this presentation
UK trade balance and the real effective exchange rate
IMF real exchange rate (LHS)
Current a/c deficit % GDP (RHS)
Trade balance % GDP (RHS)
140
120
6
4
100
2
80
0
60
-2
40
-4
20
-6
0
Q1 1980
Q1 1984
Q1 1988
Q1 1992
Q1 1996
Q1 2000
%
-8
Q1 2004
Sources: ONS, IMF
Please refer to important disclosures at the end of this presentation
Slowing world trade growth
16%
World export growth (%Y, goods & services)
14%
Morgan Stanley
forecasts
12%
10%
8%
6%
4%
2%
0%
2000
2001
2002
2003
2004
2005
2006
Source: IMF, Morgan Stanley Research Estimates
Please refer to important disclosures at the end of this presentation
Morgan Stanley forecasts – central case
Year-on-year (%)
2003-4
2004-5
2005-6
2006-7
2007-8
2008-9
2009-10
Real GDP
2.75
2.9
2.1
2.8
2.5
2.5
2.5
Real Household
Expenditure
2.6
2.6
1.9
2.5
2.4
2.3
2.3
Consumer prices
1.3
1.3
1.5
2.0
2.0
2.0
2.0
GDP deflator
2.8
2.0
2.3
2.7
2.8
2.8
2.8
Money GDP
(£ billion)
1116
1170
1222
1290
1358
1430
1506
Sources: Morgan Stanley Research estimates
Please refer to important disclosures at the end of this presentation
Saving rates under central and ‘worst’ case
20
18
Morgan
Stanley
forecasts
16
14
Whole economy
gross saving
rate
National net
saving rate
12
%
10
H/H saving
ratio
`
8
6
H/H saving
ratio – Morgan Stanley
central case
4
2
0
1987
1991
1995
1999
2003
2007
H/H saving
ratio – Morgan Stanley
'worst case'
Source: ONS, Morgan Stanley Research Estimates
Please refer to important disclosures at the end of this presentation
Morgan Stanley forecasts – worst case
Year-on-year (%)
2003-4
2004-5
2005-6
2006-7
2007-8
2008-9
2009-10
Real GDP
2.75
2.76
0.66
1.44
2.00
2.25
2.25
Real Household
Expenditure
2.60
2.44
-0.14
0.63
1.0
1.0
1.0
Consumer prices
1.25
1.3
1.2
1.5
1.8
2.0
2.0
GDP deflator
2.75
2.00
2.10
2.30
2.50
2.80
2.80
Money GDP
(£ billion)
1116
1169
1201
1246
1302
1368
1437
Sources: Morgan Stanley Research
Please refer to important disclosures at the end of this presentation
Disclaimers
Important US Regulatory Disclosures on Subject Companies
The information and opinions in this report were prepared by Morgan Stanley & Co. International Limited and its
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Global Stock Ratings Distribution
(as of December 31, 2004)
Coverage Universe
Stock Rating Category
Count
Overweight/Buy
Equal-weight/Hold
Underweight/Sell
Total
632
880
374
1,886
Investment Banking Clients (IBC)
% of
Total
34%
47%
20%
Count
249
310
99
658
% of
Total IBC
% of Rating
Category
38%
47%
15%
39%
35%
26%

Data include common stock and ADRs currently assigned ratings. For disclosure
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Disclaimers
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